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Forward vs. Future Prices

Can someone please provide me a clearer understanding of the schwesher explanation for the following question. I don’t understand the negative aspect of mark-to-market of a future.

When interest rate changes are negatively correlated with the price changes of the asset underlying a futures/forward contract:

A. Forward prices are higher

B. Futures prices are higher

C. Futures prices may be higher or lower depending on the risk-free rate and price volatility.

Answer: A

Explanation: A negative correlation between asset price changes and interest rate changes makes the mark-to-market feature unattractive to a futures buyer. This leads to a lower futures price, compared to the forward price on an otherwise identical contract.

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You earn interest on the balance in your margin account.  When prices move favorably, the balance in your margin account increases; when they move unfavorably, your margin account decreases.  You’d prefer that the increases come when interest rates are high, so you earn higher interest on a larger balance.  If you have to have decreases, you’d prefer them when interest rates are low, so that you lose less interest on the lower balance.

If you’re long the futures and interest rates have a negative correlation to the underlying asset price, then as the price goes up, your margin account goes up, but the interest rate goes down (and vice-versa); this is the opposite of what you’d like.  Thus, you’d pay a lower price for the futures contract; forward prices (with no margin account) would be higher than futures prices.

Simplify the complicated side; don't complify the simplicated side.

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In the forward pricing equilibrium theory , Forward prices and interest rate are negatively coorelated with each other.So when Forward prices are higher interest rates are lower and vice versa. This same theory also works in the the above question . So the ans is A.

 

One of the key differences between a forward and a future is that future settles periodically.  What that means as  investor is that you get CF from a future contract and therefore are exposed to reinvestment risk.

with that in mind,

When you long a future contract and the asset value goes up, you make $ and will reinvest at

1) higher rate if price and interest rate are positively correlated (you would prefer a future under this scenario to get the CF and reinvest at higher rate, hence future price > forward price).

2) lower rate if price and interest rate are negatively correlated ( you would prefer a forward under this scenario to avoid the CF from futures which you have to reinvest at lower rate, hence future price < forward price).

S2000magician wrote:

You earn interest on the balance in your margin account.  When prices move favorably, the balance in your margin account increases; when they move unfavorably, your margin account decreases.  You’d prefer that the increases come when interest rates are high, so you earn higher interest on a larger balance.  If you have to have decreases, you’d prefer them when interest rates are low, so that you lose less interest on the lower balance.

If you’re long the futures and interest rates have a negative correlation to the underlying asset price, then as the price goes up, your margin account goes up, but the interest rate goes down (and vice-versa); this is the opposite of what you’d like.  Thus, you’d pay a lower price for the futures contract; forward prices (with no margin account) would be higher than futures prices.

In order to know how much higher for Future price will be, do we use some form of model to calculate and justify? Or do we use the mkt price to determine?

Pyng wrote:
S2000magician wrote:
You earn interest on the balance in your margin account.  When prices move favorably, the balance in your margin account increases; when they move unfavorably, your margin account decreases.  You’d prefer that the increases come when interest rates are high, so you earn higher interest on a larger balance.  If you have to have decreases, you’d prefer them when interest rates are low, so that you lose less interest on the lower balance.

If you’re long the futures and interest rates have a negative correlation to the underlying asset price, then as the price goes up, your margin account goes up, but the interest rate goes down (and vice-versa); this is the opposite of what you’d like.  Thus, you’d pay a lower price for the futures contract; forward prices (with no margin account) would be higher than futures prices.

In order to know how much higher for Future price will be, do we use some form of model to calculate and justify? Or do we use the mkt price to determine?

In the real world you would create a model to determine the appropriate price difference.

On the Level II CFA exam they won’t ask you how much the price difference will be, only whether it will be positive, zero, or negative.

Simplify the complicated side; don't complify the simplicated side.

Financial Exam Help 123: The place to get help for the CFA® exams
http://financialexamhelp123.com/

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